T-CH3 Chapter 3 Financial Analysis

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Profiting from Irrationality Behavioral Finance
in the Philippines
Francisco L. Roman Jr., DBA
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• Table of Contents
• I. Is Behavioral Finance a Growth Industry?
• What is Behavioral Finance?
• Behavioral AND Traditional Finance
• Examples of Terms
• II. Behavioral Finance in the Philippines
• FINEX Survey Findings
• Analysis and Preliminary Conclusions
• III. Wrap-Up
• Usefulness for Corporate Finance
• Words of Caution

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Part I Behavioral Finance
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Behavioral AND Traditional 1/2
BEHAVIORAL FINANCE The idea is simple Investors
are not as rational as traditional theory has
assumed, and so biases in their decision-making
can have a cumulative effect on asset prices.
TRADITIONAL FINANCE In efficient market theory,
assets are correctly priced because supply and
demand reflect aggregate public knowledge about
those assets, and that the movement of stock
prices can not be reliably predicted based on
past results.
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Traditional AND Behavioral 2/2
Fundamental Heuristic ( Technical) Beliefs An
alyses (Biases)
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Two Points of View
Behavioral Finance models will NOT replace the
theory of Efficient Markets.
The idea that investors and managers are NOT
uniformly rational makes intuitive sense.
Basic Market Psychology Buy out of Greed.
Sell out of Fear. Behavioral Finance goes Beyond
Greed and Fear.
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The Traditionalists Critique

• Overemphasis
• On (Unrepresentative) Anomalies
• On (Before After) Events
• Ambiguity Over/Under Reaction
• Not Scholarly Enough
• An excuse to evade economic theory
• Behavioral Finance has NOT shown that the
  tendencies of individuals, when aggregated,
  have an impact on world prices.

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Behaviorial Finance Response
In finance, you are playing against people, who
value assets on the basis of their expectations
about the future. These expectations are
ephemeral, or at best unstable.

• Valuing shares is an ART (not a science)
• Globalization creates info. lags.
• Many critical assets are intangible.
• Brands patents, learning organizations
• Trust is still critical (Enron et al.).
• And ephemeral

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RECONCILIATION 1/3
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Efficient market models of rational behavior are
not BAD descriptions of reality. Theyre just NOT
going to capture everything. Since bubbles and
other anomalies have real economic effects, and
occur often enough, it is worth devoting time and
effort trying to understand what drives them and
whether their impact can be contained.
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RECONCILIATION 2/3
From the Traditionalists Theres a big demand
for behavioral finance among the practitioners
because nobody wants to believe the markets are
efficient, but if theres so much money on the
table, how is it that professional managers cant
do any better than index funds?
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RECONCILIATION 3/3
From the Behaviorists BF doesnt say Theres
easy money. Go after it. It says that psychology
causes market prices and fundamental values to
part company for a long time.
Potential profit opportunities come packaged
together with additional risk, and smart money
cant or wont take a large enough bet to
eradicate the anomalies, and wont be able to
arbitrage away the anomalies and return the
market to equilibrium.
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Examples of Terms 1/3
HEURISTIC BELIEFS Rules of Thumb
Biases Disposition Effect Herd Mentality
Overconfidence Regret Minimization
Representativeness
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Examples of Terms 2/3

• HERD MENTALITY
• Start Investors depend on buzz/rumors.
• The Herd Other investors join the crowd.
• Reversal Initial pull-outs accelerate
• REPRESENTATIVENESS
• Recall of past performance.
• Persistence winners are winners v.v.
• Tendency to use media-based info.
• OVERCONFIDENCE Analysts are 80
• confident but only 60 accurate.

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Examples of Terms 3/3

• REGRET MINIMIZATION
• Dependence of the analyst
• Share the credit for good performance.
• Blame the analyst for poor performance.
• DISPOSITION EFFECT
• Loss Averse hold losers too long.
• Ego-driven
• Uneven expectation
• (of recovery breaking-even)
• Risk Averse sell winners too early.
• Fear of price reversal.

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Findings From DC Markets1/4

• Professional traders can be loss averse.
• Herd mentality will raise stock prices
  (Irrational Exuberance).
• The Greenspan Put

Just as an investor can can set a floor for the
price of a security by buying a put option, so
Mr. Greenspan will provide a floor for the stock
market by cutting interest rates when it gets too
low for his liking.
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Findings From DC Markets 2/4

• Bubbles/Anomalies exist persist.

One weakness of the efficient market theory is
the assumption that arbitrage by the informed
(rational investor) against the uninformed (e.g.,
biased) is riskless and costless.
LTCM
Assume a relatively small volume of shares in
circulation that can not meet the demand by
would-be shorters. Peoples with imperfect
valuations can set prices that are out of line.
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Findings From DC Markets 3/4

• Computer models imply that price patterns are
  created by the collective actions of market
  traders themselves e.g., a trend in rising
  prices can be interpreted as a buy or a sell
  signal.

• The more orderly a market appears (e.g.,
  regularly rising P Q), the less stable it is
• The Domino Effect

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Findings From DC Markets 4/4

• Economists have a problem with self-control.
• We think it is not a problem.
• Homo Economicus is always rational.
• But time-inconsistent behavior persists.
• The Doughnut Dilemma ( the Borrower)

• Other Heuristics
• Instant Amnesia
• Arbitrary Obsessions
• Fatal Optimism
• Compulsive Monitoring

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Findings From LDC Markets 1/2

• In general RoE works better than P/E Multiples.
• DCF projections are guesses.
• The past becomes a good predictor
• In South Korea, the prices of the worst firms in
  the last 6 months did better in the next 6.
• Government bail-outs implied put
• In Taiwan, it is the ratio of RD to Sales.
• In China RP, it is debt CA/CL, etc.

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Findings From LDC Markets 1/2

• Dividends are the GOOD NEWS
• In HK, China, Singapore Malaysia
• 50 give gt bank deposit interest rates
• In USA, only 7
• Since 1991, two-thirds of investment returns
  came from dividends (not capital gains).
• A wasteful use of scarce capital?

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Part II The FINEX Survey
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Survey Items
HEURISTIC BELIEFS gt Rules of Thumb
Biases gt Disposition Effect gt Herd Mentality
gt Overconfidence gt Regret Minimization gt
Representativeness
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Case Examples 1/2
DISPOSITION EFFECT

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Case Examples 2/2
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Survey Sample 1/3

• Methodology
• Two Runs July 4 Aug 28
• Phone E-mail Follow Up
• All Finex Members
• Excluding errors in addresses
• 75 Responses as of September 19
• 6 Point Rating Scale (most of the time)

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Survey Sample 2/3
Others
Banks
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Commercial
Mfg.
Other Fin.
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Survey Sample 3/3
Senior
Mgt.
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CFO
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CEO
Others
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The Framework
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On the Two Paradigms 1/2

• Ranking Factors in Investing
• Fundamental Analysis (25/27 respondents)
• Technical, Risk-Return, Earnings Report (11)
• Time-Based Investing
• Short Term 60-90
• Medium 15-30
• Long 0-100
• Use of Charts
• As CFO As Individual
• Often (6/14) Once in a While
• Sometimes (78/22)

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On the Two Paradigms 2/2

• Use of Rules-of-Thumb from Experience
• Significant More Significant (20/25)
• Ranking Reasons for Losses
• Market Stock Price (15/21)
• Interest Rate (6), Time(8), Luck (11)

Investors combine both paradigms.
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Disposition Effect 1/4

• To What Extent Does a Paper Loss
• Affect your future investments
• Significant 15/24
• Your evaluation as a CFO
• Significant More Extremely (14/23)
• Less Significant Insignificant (9/23)

• Holding on to LOSING Stocks
• 23/23
• Up to what point?
• 11-20 Decline (18/23)

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Disposition Effect 2/4

• Compensating for the Loss
• Sometimes Often (15/24)
• Once in a while Hardly (9/24)
• And how often did the losing stock return to
  its original price?
• Sometimes Often (16/23)
• And Your Response (multiple answers)?
• Buy Other Equity (15)
• Buy Non-Equity (14)

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Disposition Effect 3/4

• Selling WINNING Stocks
• Not based on time but rise
• Between 11-20 (12/23)
• Between 21-40 (10//23

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Disposition Effect 4/4
Investors respond to paper losses/gains. Floor
Hold losers up to a 20 decline. Ceiling Sell
winners after a 20 rise. While waiting, will
NOT buy the same stock. Instead, buy OTHER stock
or asset.
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Analysts Rate Themselves 1/2
Overconfidence?

• In predicting turning points
• (28 responses)
• Fair 6
• Satisfactory 17
• More than 5
• 6-point scale (Poor, Very Good, Excellent)
• Investment Gains
• Before 1997 Post-1997
• 41 gt (21/24) 11-30 (14/24)
• lt10 (5/24)

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Analysts Rate Themselves 2/2

• Performance Over Time/Administrations

Aquino Ramos Estrada Arroyo
Poor 0 0 6 4 Fair 3 1 7 4 Satisfactory 2 6
5 11 Very Good 9 12 0 0 Excellent 0 1 0 0
Let the Viewer decide.
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Non-CFOs Rate Analysts

• 17/46 Firms use investment analyst or team
• Often (6) Always (9) follow the advise.
• But get contrary results Once in a While (6)
• Sometimes (10)
• But when accurate, the rise in price is
• 21-30 4/16
• 31-40 2
• 41-50 3
• gt50 7

When theyre right, they deliver.
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Herd Mentality, Representativeness Regret
Minimization 1/6
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Herd Mentality, Regret Minimization
Representativeness 1/6

• Pick 1 2 best 1 worst stocks in 4
  sectors
• PSE listed companies
• Telecoms, Food, Banking, Real Estate
• Criteria
• Company Image, Fundamentals, Management
• Answers were tested against actual stock
  performance, over a 12-month period.
• Returns include appreciation (or not) any
  dividends.

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Herd et al. 2/6 Reasons for

• Companys Profile/Image
• BEST WORST
• Stable Political in Nature
• Conservative Bad Reputation
• Strong Franchise Too Speculative
• Blur Chip No New Developments
• Dominant Unclear Business Model
• Diversified Unclear Plans

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Herd et al. 3/6 Reasons for

• Fundamentals (Ratios)
• BEST WORST
• Liquid Not Liquid
• Low Debt Shareholders Reputation
• Strong PL BS Speculative
• Good/High RoE No New Developments
• Large Share Base Poor transparency
• Cash-Rich Weak Cash Flows

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Herd et al. 4/6 Reasons for

• Management
• BEST WORST
• Transparent/Profl Past Baggage (Old Mgt.)
• Market Leader Poor Credibility/Governance
• Foreign Backing Speculative
• Prudent Secretive
• Clear Focus No Long Terms Strategy
• Good Track Record Heavy Debts

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Herd et al. 5/6 Reasons for

• Returns of the Best Choices
• with other comparisons
• if data available
• PROPERTY RETURN
• ALI 45.4
• BANKS RETURN
• BPI (17.9)
• RCBC (52.9)
• EBC 1.2
• MFC 11.8

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Herd et al. 6/6 Reasons for
TELECOMS RETURN Globe 5.2 PLDT (28.9)
Digital 100 FOOD RETURN SMC 16.4 Jolllibe
e 4.9 RFM 95.1
Some Herd et al. Some Bad Calls
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Part III Wrap-Up
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Wrap-Up 1/5
For the Retail Investors Research does show
that these people tend to hold on to a losing
investment and to sell a winning investment too
quickly relative to their opportunity costs.
Retail investors who think theyre clever
enough to beat the market probably dont even
understand traditional finance ideas and should
simply follow a passive long-term strategy.
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Wrap-Up 2/5

• For the Field of Corporate Finance
• Decision biases can have a significant impact on
  how the firm fares. (The - of Enron)
• IBM altered its menu of pension funds offered to
  its employees because alternative program can
  overcome biases and enable investors to make more
  rational decisions.

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Wrap-Up 3/5

• Assuming Imperfectly Rational Managers,
• Issues for Future Research
• Why do bad capital structure decisions occur?
• What about discrepancies between market
• CFO valuation of a firm?
• How do imperfectly rational CFOs decide?

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Wrap-Up 4/5

• Rating Investors in the Philippines (54)

Aquino Ramos Estrada Arroyo Still at
Basics 16 3 7 4 Moving Up
13 14 20 11 Improved 4 14 11 26 Excelle
nt 1 4 1 1
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Wrap-Up 5/5

• Profiting from Irrationality???
• Not for the retail investor
• Inevitable
• Low trading volume (even pre-1997)
• Easy to be a big player
• Information lags (even legally)
• Pre-buying IPOs
• Order lags (both buying selling)
• Some are more equal than others
• Improving processes (internally)

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